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Financial Security – Mark Speaks in Baku

July 9, 2010

Mark was invited to speak at a NATO conference in Baku, Azerbaijan, on financial security during the global crisis. Below is the speech he made.

1. IntroductionLadies and gentlemen, good morning. I thank you for inviting me to speak to you today. It is a great pleasure for me to address the NATO International School of Azerbaijan in Baku on the subject of Financial Security.

In addition to my normal duties as a Member of Parliament I am also currently Chairman of the All-Party Parliamentary Group on Business Services, Venture Capital and Private Equity and my trip here to Azerbaijan is in my capacity as Chair of the Azerbaijan All Party Parliamentary Group. The purpose of the group is to further understanding and cooperation between the UK and Azerbaijan on a political, cultural and business level.

Whilst here I will meet Azerbaijani colleagues at the Milli Majlis and Ministry of Foreign Affairs and at the same time I am looking forward to seeing the city and experiencing the food and culture for which Azerbaijan is renowned.

I imagine most of you are not intimately familiar with British politics so I would like to first provide you with a short introduction on my background and role as Member of Parliament for the Cities of London and Westminster. I will then talk to you about our experience in the UK and follow on with an internationally focused roundup on aspects Financial Security that most concern me as an MP.

2. The ConstituencyI was recently re-elected as a Member of Parliament to represent the constituency of Cities of London and Westminster. The constituency covers the City of London and southern portion of the City of Westminster in Central London. This comprises much of the commercial, historical and financial heart of London, including the Square Mile, St. Paul’s Cathedral, the Houses of Parliament, Trafalgar Square, Buckingham Palace and Hyde Park. The queen is in fact one of my constituents, as is David Cameron!

“The City” itself houses the London Stock Exchange which trades in shares and bonds, Lloyd’s of London which deals with insurance and the Bank of England, the central bank of the United Kingdom. There are also over 500 banks represented, with established leads in areas such as Eurobonds, foreign exchange markets, energy futures and global insurance. The Alternative Investment Market has been a growth area over the past decade, allowing London to also expand as an international equity centre for smaller firms.

* 300,000 people travel into the City a day to work * over 500 international banks make their home in the Square Mile * The City is the recognised world centre for the insurance industry * 8,600 people reside in the City * Over four million people visit each year

The world’s leading business and financial centre demands a bespoke police force, which is equipped to protect and support this unique environment, and to meet head-on the policing challenges it represents. This force is the City of London Police. They have the largest Fraud Squad in the United Kingdom and are responsible for policing London’s and the UK’s main financial hub.

This department investigates what could be described as the “traditional” fraud offences, such as banking frauds; insurance frauds; investment frauds; insider dealing frauds; advance fee frauds and Internet frauds, amongst others.

Central London financial services involve skills, roles and markets which are unique within the UK. Other UK financial centres, including Edinburgh, Manchester, Leeds and Birmingham lack the range of specialism on offer in the capital. This dominance, and London’s key role in international finance, owes a lot to history, building on institutions, business, reputations and skills laid down in earlier eras, when London was an imperial centre. But the City’s rebirth as a dynamic financial centre in the 1960s, and its regeneration from the mid-1980s, clearly depended on a more vigorously competitive stance, vying with New York in particular for international business. After the deregulation initiative known as “big bang” the city benefited from less onerous regulatory restrictions, from opening itself up to foreign participation and the removal of internal barriers to change.

In the process, the City has reinforced its position as a centre in which to do business. Thus in 2007, according to the London Annual Business Survey, there were some 54,000 jobs in foreign owned financial service firms in the City of London, representing 30% of the total. Effectively it seems that London has become a second home base to a series of overseas banks, notably from New York. The stability of this role has been tested during the present economic crisis, but there has been no serious evidence of any of the surviving finance houses seeking to ‘go home’ – though, in practice the sector as a whole seems to have suffered less from the downturn than a number of other productive sectors.

Innovation in various forms has been a notable feature of London financial service development over the past decade in particular. The rapidity with which innovations have emerged and been adopted over this period has reflected a combination of technological, institutional and market developments, with similar significance for both global financial centres together with some factors which particularly boosted innovation in London. Among these London-specific factors were: • Strong financial incentives; • Liberal immigration control, enhancing London’s capacity to attract talented young workers from many countries; • A principles-based regulatory regime under the Financial Services Authority (FSA); • Development of a complementary relationship between New York and London operations, with products initially developed in the former being adapted and rolled out for international application through London

3. Changes to the British SystemHowever successful this approach has been in past, the financial crisis demonstrated the need for fresh regulatory policies and more proactive supervision, it also demonstrated the need to bridge the gap between macro-prudential policy and the supervision of individual firms. The British Chancellor, George Osborne, has accordingly announced plans for changes to the financial system, handing some regulatory powers back to the Bank of England. These changes will include establishing within the Bank a Financial Policy Committee and the creation of two new regulators, a new Prudential Regulator under the Bank of England; and a new Consumer Protection and Markets Authority (CPMA).

The Financial Policy Committee will have the responsibility to look across the economy at the macroeconomic and financial issues that may threaten stability. The Governor will chair the new Committee. Its membership will include the Deputy Governors for monetary policy and financial stability, the new Deputy Governor for prudential regulation, the Chair of the new Consumer Protection and Markets Authority, as well as external members and a Treasury representative.

Supervision of individual banks will be carried out by the Prudential Regulatory Authority, a legally separate but subsidiary part of the Bank that will replace the FSA in 2012.

On retail customer protection, there has been a shift in our past approach, moving to a more proactive policy as set out in the recently published Retail Conduct Strategy. A new body, The Consumer Protection and Markets Authority will have a strong focus on this challenge, while also keeping close watch on conduct issues in wholesale products, ensuring the integrity of the UK’s financial markets in order to preserve their reputation for transparency and efficiency as well as the UK’s reputation as one of the world’s leading global financial centres

There are important issues still to be resolved – in particular the arrangements for our Enforcement activities and for those Markets activities which relate to exchanges and clearing infrastructure – but the overall future shape of financial regulation is now much clearer and we are in a strong position to create a future regulatory system which builds on the FSA’s achievements over the last few years of major change.

Given that a large part of the financial services sector is based within my own constituency I have a special interest in it’s growth and stability. As an MP I am concerned that regulation should not stifle the industry whilst at the same time making sure that there are sufficient safeguards in place to address stability of the system as well as misuse for terrorist financing or organised crime.

4. Financial Crime in the UK

Assessing the scale of financial crime in the UK is a difficult task given it’s shadowy and secretive nature. There are no specific figures but to get an idea we can look at Home Office estimates of the revenue made by organised crime in the UK which is in the order of £15 billion a year. Of course this is not all the product of financial crime, but it gives us an idea of the scale of the problem and we can expect that a significant amount of the proceeds will pass through financial systems at some level.

According to the UK Threat assessment report for 2010, organised criminals are increasingly using Information and Communications Technology to support a wide range of traditional and newer criminal activities, to enhance their communications and operational security and to gain access to criminal financial markets. The Internet, in particular, has provided criminals with various money-making and money laundering opportunities, and as commercial and business use of the Internet has developed, its exploitation by organised criminals and terrorist financiers has also grown. Alongside this increased use of technology, criminal and terrorists have become more aware of the value of information, especially personal data. Data theft is fast becoming a cornerstone of financial crime in the UK and is a key factor that threatens our financial stability.

Highly skilled criminals are constantly scanning operating systems and application software for new security vulnerabilities. Once discovered, they develop and deploy new attack tools to breach the security of these systems. Where known security vulnerabilities are not addressed by organisations it results in successive data breaches. This, together with instances of inadequate implementation of data security standards, highlights the fundamental need for the public and private sectors to do more to protect the security of data they hold on customers and clients.

5. Financial Security in the Shifting Global Economy and the era of Terrorism

The increase in sophistication and frequency of terrorist attacks in the last decade, alongside the fallout from the financial crisis, have paved the way for the establishment of a solid international finance regime whose participants include non state actors. The ramifications of this regime are significant not only for the identification and suppression of the financing of terrorism, but also for the survival and development of the financial industry and uninterrupted continuation of business. The combined achievement of these two objectives should be the target whenever we look at new methods of Financial Security.

As the numerous speakers have no doubt described in this conference, the challenges that exist in ensuring that financial security measures are implemented, regulated and effectively maintained are many, and they continue to grow. When looking at the future of financial security, numerous factors emerge that require immediate and ongoing attention.

The international financial community is now operational 24-hours-a-day: as one financial centre closes, another opens. This factor cannot be ignored in relation to all financial security issues in the modern age, and the unknown future developments that will take place in the sphere.

Technology is the key driver behind the modern financial world. Monetary transactions can be made by a huge variety of methods: computers, telephones, the Internet, text messages, money transfer agencies, to name but a few. Each technological advance designed to simplify our everyday lives brings with it a further complication for regulation and crime prevention.

In a recent statement, Murilo Portugal, Deputy Managing Director, International Monetary Fund (IMF) said the following:

“Global financial stability hinges on collective action at the international level, but also on effective national systems. Robust anti-money laundering and combating the financing of terrorism regimes are an important pillar of the international regulatory and supervisory system and part and parcel of the current efforts to strengthen the global financial framework.”

Mr Portugal’s statement recognises and outlines the need for collaboration at both a national and international level when tackling the issue of money laundering and the financing of terrorism when ensuring global financial stability.

The topic of how to effectively tackle the financing of terrorism is integral to the future of international financial security. In 2003, the Financial Action Task Force (FATF), the inter-governmental body whose purpose is the development and promotion of national and international policies to combat money laundering and terrorist financing, set the global standard for anti-money laundering and combating the financing of terrorism (AML/CFT). As you will be aware, FATF has established 40 recommendations on Money Laundering and nine special recommendations on terrorist financing.

FATF’s recommendations highlight the need and importance of international-cooperation in tackling the financing of terrorism. However, the challenges that exist in effectively estimating the extent of terrorism funding in the context of financial security in the global market are plentiful. The World Bank, in its publication: Reference Guide to Anti-Money Laundering and Combating the Financing of Terrorism, highlights the link between Money Laundering and Terrorist Financing and makes clear that: “by their very nature, money laundering and terrorist financing do not lend themselves to statistical analysis.” This is a global phenomenon, making exact estimates almost impossible to surmise.

6. Emerging Internet Crime Threats

Virtual Networks are one of the more worrying aspects of this global phenomenon and one of the most significant emerging threats. The most prevalent e-crime criminal activity is conducted within multi-skilled, virtual criminal networks, whose structures are different to traditional organised crime groups. Virtual criminal networks are often focused around an online meeting place, either a web forum or Internet Relay Chat (IRC) channel. Members rarely meet in person and individuals are known only by their online alias or nickname.

Criminals engaged in online fraud and money laundering can now operate practically anonymously and on an international level, making use of fast and reliable systems to enable them to do business with each other. They have adopted electronic currency systems as their preferred method. These systems share features that appeal to online criminals engaged in fraud: they are anonymous and almost instantaneous; they charge relatively low commissions; and payments are irrevocable.

Additionally, with the advent of internet banking, “following the money” to locate and prosecute money launderers and criminals has become more difficult than ever. It is not always clear whether an account is accessed from a country other to where the money is held, and account managers may simple be too busy to monitor all the activity of individual account holders.

It isn’t just online banks that are vulnerable. In the UK, Internet-based gambling operations have also attracted attention and can act as a haven for illegal cash-washing operations. The Financial Action Task Force has said there is evidence that criminals are using online casinos to commit crimes and launder the proceeds. Aside from the problems inherent with Internet banking, online casinos further complicate tracking of questionable transactions because gambling records are software based and at the gambling site – often located offshore. That makes evidence gathering more difficult because the records are harder to find and may not exist at all.

It is likely that e-criminals will become more sophisticated, for example through the use of more advanced “malware” and “botnets” (networks of compromised internet-connected computers) which will allow them to steal more private data and effectively conceal their activity. E-criminals will continually adapt their tactics, as new defences are implemented by software and anti-virus vendors, in order to serve the illicit market in compromised private data.

Another area of concern is in Online Virtual Worlds and Massively Multiplayer Online games (MMOG), as these continue to develop they create new opportunities for money laundering, criminal communications, and compromise of private data. Some of these online environments have millions of users and many employ internal electronic currencies to allow their members to buy and sell goods and services. These systems could be exploited by criminals for money laundering and identity theft.

The increasing diversity of web-based technologies will create new vulnerabilities that e-criminals can use to access and exploit victims and conceal their own activities. This type of web content is often more vulnerable because it is generated by users rather than large corporations and user generated applications may be more likely to contain security vulnerabilities than those developed by professionals.

7. Informal Value Transaction Systems

Moving in the opposite direction to e-crime, it seems to me that the challenges of assessing and evaluating non-regulated, untraceable informal value transaction systems increase exponentially. There is little point in overburdening official financial markets with regulation while other means of monetary transaction remain largely un-policed.

Most of the evidence collected and collated by the international community suggests that terrorist groups are exploiting the international trade system, and making fraudulent transactions to transport money for illegal purposes via regulated channels, but other means of monetary transactions are of great concern in the fight against the financing of terrorism. Private donations, physical cash amounts being taken across borders and unregulated value transfer systems and alternative remittance systems all present major issues to international financial intelligence.

The United Nations’ Counter-Terrorism Implementation Task Force (CTITF), acknowledge that although the perception of non-traditional money methods of money transfer pose a great risk, it is unclear whether these systems are more susceptible to criminal abuse than regulated ones.

One example of concern is that of the Hawala money transfer system. Hawala, which is also know as Hundi, is an informal value system most commonly used in regions including the Middle East, North Africa, the Horn of Africa, and South Asia, but most be noted for its worldwide presence. The system was developed prior to the introduction of Western banking practices and differs to other alternative remittance systems, such as the ‘chop’, ‘Chit’ or ‘Flying Money system’. The basis of the Hawala system is trust, connection networks and brokers.

The major difficulty that the Hawala system presents to international regulators is that the system works by transferring money without immediately physically or electronically moving the money – money transport without money movement.

Unlike the majority of speakers at this conference, I cannot claim to be a financial services industry professional but the one thing that has struck me when researching the Hawala system is the further difficulty in regulation when the remittance of a particular transaction does not need to be in the form of a cash settlement. It is this additional detail that highlights the difficulty in regulating alternative remittance systems. Whilst I am not aware of any immediate evidence to suggest these networks are being exploited, the potential for misuse is significant and there are no immediate answers in sight as to how these systems might be monitored more effectively.

8. Conclusions

The events of the last few years have brought financial security under the spot light like never before. The evolving threat from organised crime, combined with the advent of the financial crisis, have greatly increased pressure on the financial markets.

Technological advances both aid and hinder the fight against financial crime. The perpetrators of financial crime have been consistently effective in creatively bypassing the majority of measures implemented to safeguard financial systems and services, and in exploiting regulated systems. Financial security and financial crime in the modern age is predominantly driven by technology. The sophistication of criminal techniques, and the opportunity that exists for monetary transfers, has developed at a startling rate, so it is easy to appreciate the enormity of the task in hand, however vigilant the work of global financial system regulators.

At the same time we have also witnessed the shock from a financial crisis that has resulted in the collapse of large financial institutions, the bailout of banks by national governments and downturns in stock markets around the world. Many people believe that this was the result of a lack of oversight by regulatory bodies, allowing the overvaluation of assets.

The temptation is therefore strong to increase regulation to counter both the criminal threat and the perceived failures that allowed the financial crisis to develop. As I outlined earlier, in the UK we have introduced regulatory changes and other countries have implemented their own measures, but significant risks remain for the world economy over the 2010–2011 and we must be vigilant to ensure that we do not overburden the markets with regulation and risk stifling the fragile recovery.